Our Investment Philosophy - a short overview (Millionaires Club)

Investment Philosophy

An investment philosophy is basically just your strategy for how you think you are able to make money in the market. The operative words are "How", "You" and "Money", meaning that you've got to have an idea of how you think investing works, how you work yourself and what your money goals are - i.e. do you want to simply retire with X amount or do you want to get rich as Midas?

These three things have to fit together: if you believe the market is always pricing everything to perfection it doesn't make sense for you invest in order to 'beat the market' - your "How" and your "Money" doesn't match up.

Or if you think that long-term buy-and-hold-forever investing is the only true path to riches but you are updating your phone every 10th second to get the latest stock price (while driving, of course)... time to look in the mirror and ask yourself if this is going to pan out as you hope.

So if you know where you want to go, can see how that could be done AND you think you are the person to do it - bingo: investment philosophy completed.

So what does this mean for how I invest the Millionaires Club portfolio?

1 - It's a stock picking competition: so naturally the goal is to beat the others AND beat the benchmark. I'd also say that if you're investing actively you ought to try and beat the market. This is our goal - inside the competition and outside.

2 - Stocks Only: if you have a 15+ year time horizon you shouldn't own anything but stocks in my opinion. If you are young and can look forward to a lifes worth of earnings I'd not even argue with you if you leveraged your portfolio a little bit (like +50%) or de-facto leveraged it with options trading. The whole 'Risk-Reward' conversation basically boils down to this picture of the capital market line:

Stocks return about 10% a year (dividends reinvested over the last 100 years). But volatility is high, meaning you can wake up any given day and be up or down A LOT!

Here are the last 11 years worth of returns for the S&P 500 to illustrate:

The thing is: volatility evens out and you are paid handsomely to just sit on your hands and do nothing. Best job in the world, if you ask me.

In The Millionaires Club competition it's all about stocks so the decision is already made. But it's how most people should invest anyways.

3 - Concentration: I'll own 5-8 stocks only. It simply doesn't make much sense to own more in my opinion. If the 8 stocks are uncorrelated you're plenty diversified:

As the figure shows the traditional dictum to own at least 30 stocks for a "well diversified portfolio" is simply a recommendation if you want to build your own index fund.

Owning 100 stocks - like many mutual funds do - it's almost impossibly hard to do different than the market - in which case you might as well save the management fees and go for an index fund.

If you want to outperform you _have_ to concentrate (or pick bundles of stocks that correlate according to a strategy, but that's for another post).

And you get a lot (a LOT!) of added value from forcing yourself to truly choose which stocks to own. If you have no max on the number of stocks you'll own, you'll just buy every half arsed idea you have and end up with a portfolio that is less good than your best thinking. And why the hell would you want that?

(Also you'll likely end up with less trading costs and less capital gains taxes).

4 - Long Term Focus: I don't care about what the market does overall - I care about how the businesses I own stack up at a real economic level. Are they producing a better-than-average return on equity without a stupid amount of leverage? And do I believe they will continue to do so? If the answers are "Yes & Yes" it's really secondary if a company is down 20% against the market in any given period. Because the gravitational pull of the good underlying business will eventually pull the stock price back into the range of the reasonable.

I know of no super investor who says that they can predict the market. Zero. Don't try.

(The 5 businesses in the Millionaires Club Portfolio returned 39,2% on equity last year)

5 - US Stocks - mostly micro cap: this is an arbitrary choice, but most of the other portfolio managers in the competition were focused on Danish or European stocks, so we choose to focus on US equities. Consequently we benchmark ourselves against the S&P500. Could we have used the Russell 3000? Sure. But nobody in Denmark knows what that is, so we went for the S&P.

Also we tend to focus on small, micro or even nano-cap companies. This has several advantages to the common investor:

Smaller companies are usually simpler to understand than big ones. They have fewer businesses rolled into them.

Less or no coverage by analysts leaves much more room for mispricing by the market. Your own research actually matters.

Smaller companies have no institutional investors to 'floor' the price, which means that they can fluctuate far more - giving you much better buying opportunities.

And let's get this into perspective: a small cap US company is still usually a multi-$100 million business with a strong track record. So small compared to the corporate giants but still far larger than what most businesses we interact with on a daily basis.

--

Okay, so the above pretty much covers the "Goals" and the "How" part of the investment philosophy - it's a series of choices that's designed to give us the best shot we can at outperforming.

But where is the behavioural economics element????

It's in the "You" part of the Investment Philosophy. Knowing how the mind works (and doesn't work) is indispensable in trying to execute almost any investment strategy well.

A few random facts:

After 5 variables we don't get more precise as investors (machines do: humans do not), but we think we do. So building screeners with 20+ variables makes us feel like we're more sophisticated than we really are.

When evaluating a course of events we focus on peaks and the end: so when buying a stock we remember the top point and the bottom point + focus on the selling price. This is not beneficial in remembering or evaluating our ongoing thinking as we owned the stock - and it's also a big part of why we don't want to sell losers.

Our memory sucks: if we don't force ourselves to write down what we thought about a stock when we first buy it our minds will warp our memory to fit the events as they unfold. Don't think of your memory as an unbribable historian. Big mistake - your memory is your biggest fan. Madly in love with you and willing to tell you anything you want to hear at any time. It will even work hard to shut up your real friends who are trying to tell you some much needed truths.

... and so on.

Very few people I know are ignorant about this: it's common knowledge nowadays that 'we're all irrational' - but I know almost nobody who actually takes this simple idea seriously.

So we tried to do that, by asking the question: how do we de-irrationalise investing?

We came up with the following 4 broad answers:

Identify: we do lot's of things to force ourselves to know as much as we can about the stocks we buy - and only buy the stocks we really, truly understand. Owning a concentrated portfolio is one such self-imposed restriction. Always explaining the investment thesis in writing is another (nothing clarifies stupidity like ink). Owning stocks long-term is another. It's simply accepting that we can have deeper knowledge in spots than we can broadly. It's also suffering the boredom of not constantly reading about new 'fresh' ideas, but keeping the nose to the grindstone and just getting to know fewer companies far better.

Quantify: we do as deep financial analysis as we can - that is one thing. Also we quantify our predictions. In excruciating detail. We predicted a 29% chance of a non-controlled Seadrill bankruptcy for example. Not 30%. Not 28%. And we update those predictions and understandings as we get new information (bayesian updating). Which means that quantification is a big part of owning a stock - not just buying it. This forces us to clarify our thinking - to formulate it and figure out how Information A fits together with Information B and so on. And when Information C comes along we know how to 'weigh' it in our system. If this makes zero sense to you, read here how we quantified the bankruptcy risk of Seadrill Partners.

Falsify: We try to disprove our thesis. Writing publicly about investment does this trick really well as the internet is filled with kind people who are more than willing to offer their opinions (and totally for free!). Asking trusted investor-friends to try and shoot down your thinking is also a really good idea. And finally there is a whole series of tricks you can use on your own, like asking "When this fails, how will it happen?" and trying to uncover what you've missed by asking inverted questions like "To truly miss the large picture here I should absolutely make sure to ignore..."... and if the answer is to ignore something that you haven't really dug into... you're not ready to invest.

Testify: the final step is to write everything down. Use checklists to ensure you avoid trivial mistakes and do deep thinking in the right spots (Warren Buffett does, so you should too). Write down your thinking prior to investing in an investment log. Then review often and write that down too. You'll get smarter quickly. And you'll still make mistakes, of course. But you will be far more honest and much more able to incorporate your experience into your new decisions.

So this, basically, is how we ensure that the "You"-part of the Investment Philosophy actually shows up to the party.

--

That's it folks - a quick look into how we invest in the Millionaires Club Portfolio and why.

Use the comments to ask questions and I'll be happy to clarify, expand, admit defeat etc.

1 comment

HIGHLIGHTS
Operating revenue of $276.8 million.
Operating income of $148.5 million.
Net income of $78.8 million.
Adjusted EBITDA of $161.2 million.
Cash and cash equivalents of $845.3 million.
Economic utilization of 98%.
Order backlog of $1.7 billion and average contract duration of 1.3 years as of November 21, 2017.